Arbitrage Funds

If you find that the price of the same object differs across different markets and you know that you will potentially make a profit at very low risk, ask yourself whether you are going to capitalise on it or not. Rakesh Deshmukh takes a closer look at this concept within the context of the financial markets 

During your childhood days, did you ever buy items at a low price and then sell them for more to your friends? Maybe you found a great deal on toys or any gadget at a clearance sale and then sold them to your friends for a bit more money? I have come across some mobile phone retailers in my area who keep an eye out for big sales on mobile phones announced by online shopping websites like Amazon or Flipkart. When they notice trendy phones available at a low price online, they purchase them at a discounted rate. Then, they sell that same phone in their shop for a bit more than they bought it for. They don’t do it all the time, but when they spot a good deal, they jump on it and try to make money from it. 

I hope this little explanation has created an environment and generated an interest in you to read about arbitrage and arbitrage funds. So, let’s explore together. Arbitrage is about finding a price difference of the same security between two or more markets and capitalising on it. As an investor, if you find the price of a stock to be different in the futures and spot markets, then you have an opportunity to cash in on it. 

Arbitrage funds are equity-oriented Hybrid Funds that capitalise on arbitrage opportunities in the market. These opportunities could arise from a pricing mismatch between two exchanges or differing prices in the spot and futures market. 

The fund manager of an arbitrage fund simultaneously buys and sells shares, profiting from the price difference. This strategy fundamentally differs from other forms of investing, where you typically buy an asset and wait for its value to increase before selling it. These funds fall under the ‘hybrid schemes’ category and follow an arbitrage strategy. It is required to have a minimum investment of 65 per cent in equity and equity-related instruments. Wondering what happens if there is no arbitrage opportunity? The fund manager invests in equities only when finding any arbitrage opportunity, and if there are no arbitrage opportunities available, then the fund invests in short-term money market instruments and debt securities. 

Arbitrage Funds Performance 

According to the data above, one can notice that the average returns of the arbitrage funds category surpass the benchmark return across the majority of timeframes. However, as hybrid funds, their returns are lower compared to equity funds. The highest return observed while preparing this report is 7.39 per cent, occurring over a one-year time period. 

Monthly Inflows in Arbitrage Funds 

The above graph illustrates the monthly inflow in the arbitrage funds category and provides a comparison between the monthly inflows in these funds and the net inflows in the overall hybrid scheme for the last 12 months. This data is sourced from the AMFI website. Within the realm of hybrid schemes, which comprises six distinct categories, arbitrage funds is one of them and, on an average, contributes between 65-70 per cent of the net inflows in the overall hybrid schemes. 

Pros of Investing in Arbitrage Funds 
 1. Low Risk — Arbitrage funds are perceived as low-risk investments compared to other mutual funds. Their objective of profiting from small differences in asset prices implies reduced exposure to market fluctuations. They are often compared to pure Debt Funds in terms of risk levels.
2. Ideal for Volatile Markets — Unlike most funds that may experience negative returns or high unpredictability during market volatility, arbitrage funds thrive in unstable market conditions. However, while arbitrage funds can perform well in various market conditions, their performance may not surpass that of the other equity funds that excel during trending markets.
3. Stable Returns — Arbitrage opportunities often arise from temporary pricing inefficiencies in the market. By exploiting these inefficiencies, arbitrage strategies can generate relatively stable returns over time.
 4. Tax Advantage — Arbitrage funds enjoy the benefit of equity taxation, which means they are taxed similarly to equity investments. Profits made in these funds held for less than 12 months (short-term capital gains) are taxed at 15 per cent, plus applicable surcharge and cess. If the units of arbitrage funds are sold after 12 months from the date of purchase, then profits (long-term capital gains) of up to ₹1 lakh are tax-exempt in a financial year. Longterm capital gains of more than ₹1 lakh are taxed at 10 per cent only. 

Cons of Investing in Arbitrage Funds
1. Limited Upside — While arbitrage strategies offer relatively stable returns, they often come with limited upside potential. The profit margins from arbitrage opportunities can be small, especially in efficient markets, which may limit the overall return potential.
2. Execution Risk — Arbitrage transactions need to be executed quickly and efficiently to capture price differentials. There’s always a risk that market conditions may change before the trades are completed, potentially eroding profits or leading to losses.
3. High Cost Involved — The fund manager often executes numerous trades within a day, attracting significant transaction costs. It may face high transaction costs due to frequent buying and selling to exploit market price differences. This, along with other associated costs, can impact on net profit. Unlike schemes with longer holding periods, arbitrage funds trade frequently to realise profits.
4. Limited Opportunities — As arbitrage strategies become more popular, competition among investors seeking to exploit the same opportunities can increase. This can lead to narrower profit margins and make it more challenging to find lucrative arbitrage opportunities. 

What is the Right Time to Invest?
Arbitrage funds are a unique type of fund in the mutual funds industry that tend to showcase good performance during volatile markets or when the market is choppy and unpredictable. This is when investors can seek out these funds to park their idle funds. During volatile times, when there is uncertainty and price fluctuation, these funds tend to provide stable returns. The low-risk nature and stable returns of arbitrage funds make them a popular choice for investors seeking to navigate volatile market conditions.
 

According to the above data depicting the Nifty 50 returns during different market phases, we can conclude that arbitrage funds can perform well in all market phases, including trendy markets as well as during consolidation phases. Generally, equity funds and index funds tend to underperform when the market experiences any downturn or during consolidation, or high volatility phases. In contrast, arbitrage funds have provided stable returns. Let me clarify that the returns of Nifty 50 are approximate and not exactly point to point. Additionally, the returns of arbitrage funds have been calculated based on the top-performing fund within the space, and there may be slight variations. 

Conclusion
In conclusion, arbitrage funds present a unique investment opportunity that capitalises on price differentials in the market. These funds strategically navigate market phases, demonstrating resilience and stability across various conditions. Unlike equity and index funds, which may struggle during downturns or volatile periods, arbitrage funds offer steady returns and serve as a reliable option for investors seeking stability and tax efficiency during the unpredictable direction of the markets. While acknowledging potential limitations such as limited upside and execution risks, the benefits of low risk, stable returns and tax advantages make arbitrage funds an appealing choice for navigating volatile market conditions